Evergrande …vs. Lehman and LTCM

To be clear, I’m not an expert on mainland Chinese real estate companies, nor am I 100% certain (in the way I am about Jack Ma) that I know why Hui Ka-yan is on Xi’s bad list, but here’s what I think is going on:

The mayor of every Chinese city/town is a high-ranking member of the Communist Party. He/she has economic growth targets to meet in order to remain the mayor and to become a higher-ranking official. The easiest way to get economic growth is to build something. So the mayor, with a developer in hand, goes to visit the head of the local bank. The bank president is also an important member of the Party, but lower in status than the mayor, who may be key to getting the bank president promoted. So a loan gets arranged, a big project gets built, no one looks too closely at the financial underpinnings and everybody wins.

My take on Hui is that he continuously gamed the system by being very aggressive with the amount of financial leverage he was using, to the point that he was always flirting with bankruptcy. His idea was likely that this gave him the greatest profit potential and that the mayor and the bank would always prefer to bail him out than to have an important project blow up.

Last August Beijing introduced the “three red lines,” a set of rules for maximum allowable financial leverage for property developers. Hui has been either defiant or unable/unwilling to make a satisfactory effort to comply.

This is by no means a new story for anyone interested in China or Chinese stocks. The two open issues are:

–how much exposure to a potential Evergrande default non-China financial institutions have, and

–what efforts (probably none, in my view) China will take to continue to prop up Evergrande.

Given that the story is so well-known, except to western financial TV, and that Evergrande represents less than 5% of the local property development market, the current talk of Lehman-like or Long Term Capital Management(LTCM)-like damage to financial markets seems wildly over the top.

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